I don't mean to put the following question into Forex Beginner Q&A, I know many of us have been trading FX for quite a while, but have you ever asked this question? it's not an easy question though, here it is:
We all talk about interest rate or interest rate differential to be specific, whenever we got a hint that one country is about to raise its interest rate that country's currency will appreciate because we all prefer high return than low yield, so we buy the high interest rate currency. But the interest rate parity tells us that in an world with no arbitrage opportuity the high interest rate currency will depreciate instead of appreicate, mathmetically it's easy to proof (for those who don't know the relationship: http://www.riskglossary.com/link/int...ate_parity.htm). And intuitively let's say central bank raise interest rate in order to control the inflation (that's the key target of monetary policy), so the high interest rate is associated with high inflation, the country with higher inflation should expect its currency to depreciate over time, however what we see now is the ever growing Carry trade which allows high interest rate currency to appreciate over time, NZD/JPY for example.
So the question is that how do you explain the obvious contradiction?
My explanation is that FX market is very speculative so the force behind the exchange rate is not solely determined by the fundamantals. Any other explanations are greatly appreciated. Let's solve this puzzle together.
We all talk about interest rate or interest rate differential to be specific, whenever we got a hint that one country is about to raise its interest rate that country's currency will appreciate because we all prefer high return than low yield, so we buy the high interest rate currency. But the interest rate parity tells us that in an world with no arbitrage opportuity the high interest rate currency will depreciate instead of appreicate, mathmetically it's easy to proof (for those who don't know the relationship: http://www.riskglossary.com/link/int...ate_parity.htm). And intuitively let's say central bank raise interest rate in order to control the inflation (that's the key target of monetary policy), so the high interest rate is associated with high inflation, the country with higher inflation should expect its currency to depreciate over time, however what we see now is the ever growing Carry trade which allows high interest rate currency to appreciate over time, NZD/JPY for example.
So the question is that how do you explain the obvious contradiction?
My explanation is that FX market is very speculative so the force behind the exchange rate is not solely determined by the fundamantals. Any other explanations are greatly appreciated. Let's solve this puzzle together.